Tastes and Technology in a Two-Country Model of the Business Cycle: Explaining International Comovements Alan C. Stockman; Linda L.

Tesar The American Economic Review, Vol. 85, No. 1. (Mar., 1995), pp. 168-185.
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Tastes and Technology in a Two-Country Model

of the Business Cycle: Explaining International Comovements

Trade on international financial markets allows people to insure country-spec$c risk and smooth consumption intertemporally. Equilibrium models of business cycles with trade on global financial markets typically yield international consumption correlations near 1 and excessice colatility of incestment. We incorporate nontraded goods in the model and find that the implications for aggregate consumption, incestment, and the trade balance are consistent with business-cycle properties of industrialized countries. Howecer, the model dricen by technology shocks alone yields counterfactual implications for comocements between consumption and prices at the sectoral lecel. Taste shocks produce price - quantity relationships more consistent with the data. (JEL E30, F40)

Closed-economy real-business-cycle models (e.g., Finn E. Kydland and Edward C. Prescott, 1982; Prescott, 1986) have had some success in matching features of U.S. macroeconomic data. These closed-economy models abstract from the fact that countries participate in international markets; in particular, they ignore the fact that countries have the opportunity to share nation-specific risks with other countries through the exchange of goods and financial assets. However, open-economy versions of these models that have incorporated such

*Stockman: Department of Economics, University of Rochester, Rochester, NY 14627, and National Bureau of Economic Research; Tesar: Department of Economics, University of California, Santa Barbara, CA 93106, and National Bureau of Economic Research. We thank Mark Bils, Mary Finn, two anonymous referees, and participants in workshops at the University of Chicago, the University of Southern California, UC-Davis, the Federal Reserve Bank of Richmond, Washington University, the Rochester Conference on the International Transmission of Business Cycles, the 1990 NBER Summer Institute, and the Conference on Real Business Cycle Theories at the University of Montreal for helpful comments. We also thank Ric Pace, Mike Pakko, Patrick Rowland, and Kazimerz Stanczak for research assistance. Stockman gratefully acknowledges research support from the National Science Foundation. Both authors gratefully acknowledge support from the University of Rochester Workshop on International Markets, supported by a grant from the Alfred P. Sloan Foundation.

international linkages (e.g., Enrique G. Mendoza, 1991; David K. Backus et al., 1992; Marianne Baxter and Mario J. Crucini, 1993) have been less successful than their closed-economy counterparts in replicating basic characteristics of macroeconomic time series. For example, the extension of the Kydland-Prescott model to a two-country world by Backus et al. results in much greater volatility of investment than is observed in the industrialized countries. Open-economy models have also had only mixed success in replicating key features of international data such as the comovement between the trade balance and output. The high degree of risk-sharing implicit in these models typically yields cross-country correlations of consumption that are much higher than in the data and cross-country correlations of output that fall short of those in the data. This paper proposes a two-country model that is more successful than previous models in both dimensions. The main new feature of our model is disaggregation of the economy into internationally traded and nontraded sectors. The ability to trade internationally affects an economy's behavior by breaking the link between its production and its spending on consumption and investment, permitting a country to have smoother consumption over time than in a closed economy, and a greater response of

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investment to changes in expected rates of return. This is why models driven by persistent shocks to technology, which create changes in the expected return to investment, lead to larger changes in investment in open-economy models (where goods can be imported for investment purposes) than in the corresponding closed-economy models. This also explains why technology shocks create large changes in the balance of trade in those models. Previous models, however, abstract from the evidence that roughly half of a nation's output consists of nontraded goods. This fact may be an important missing component of existing real-businesscycle models because it helps restore the connection between a nation's output and its spending. This paper examines a model in which production of nontraded as well as traded goods is subject to random disturbances to productivity. We find that the model succeeds in matching a variety of the features of consumption and production data and does reasonably well in replicating the international correlations of aggregate output and consumption and the countercyclical behavior of the trade balance. Disaggregating the model into traded and nontraded sectors permits us to examine the model's performance at replicating key moments of the disaggregated data. We do so in this paper, and the results indicate that models driven by technology shocks alone cannot account for important features of those data.' There are three separate issues. First, while a model driven by technology shocks can roughly explain the observed cross-country correlation of aggregate consumption, it cannot account for the (even lower) cross-country correlation of consumption of traded goods. Second, a model driven by technology shocks alone cannot explain the near-zero correlation between the relative price of nontraded (to traded)

goods with the relative consumption of those goods. Third, a model driven by technology shocks alone severely understates the standard deviation of the trade balance. We show that two (perhaps three) of these problems are eliminated if the model includes not only disturbances to technology, but also shocks to taste^.^ A model with some form of "demand shocks," such as the taste shocks we discuss, seems essential to explain these features of the data. The next section summarizes the main characteristics of the data that the model seeks to explain. Section I1 then describes the basic two-country, two-sector model. Sections I11 and IV discuss calibration of the model and its implications when subjected to technology shocks alone and then when subjected to shocks to both technology and tastes.
I. Empirical Regularities

We focus attention on annual data for the seven largest industrial countries: Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States. A major source of our data is the International Sectoral Data Base compiled by the OECD. We also draw on data from the OECD Main Economic Indicators and the OECD Quarterly National Accounts. A complete description of the data sources appears in the Appendix. All empirical estimates referred to in the text of the paper are based on data detrended using the HodrickPrescott filter (see Prescott, 1986X3 A. The International Regularities

A model of the international transmission of the business cycle should be consistent with the following empirical regularities. First, the correlation of output growth across countries is large and positive. Part A of
' ~ a l e r i eBencivenga (1987) studies taste shocks in a real-business-cycle model. Jess Benhabib et al. (1991) examine a real-business-cycle model with productivity shocks to household production, which are very similar to tastes shocks. 3 ~ e s u l t s ased on data filtered by first-differencing b are available from the authors upon request.

' w e calibrate the model and study its rough quantitative consistency with second moments of the data, While the model is remarkably successful in replicating many features of the data, the remaining inconsistencies suggest that further theoretical development is necessary before a model of this form is estimated or used for testing hypotheses formally.

THE AMERICAN ECONOMIC REVIEW

TABLE 1-CROSS-COUNTRY CORRELATIONS DETRENDED OF OUTPUT, PRODUCTIVITY, CONSUMPTION AND A. Correlations of Detrended Output (1970 - 1984): Country United States Aggregate Traded Nontraded Canada Aggregate Traded Nontraded Japan Aggregate Traded Nontraded Germany Aggregate Traded Nontraded Canada Japan Germany Italy

MARCH 1995

0.70 0.74 0.32

0.53 0.38 0.53 0.44 0.47 0.36

0.86 0.84 0.71 0.69 0.60 0.49 0.62 0.34 0.86

0.57 0.48 0.62 0.71 0.56 0.65 0.48 0.41 0.50 0.84 0.81 0.80

B . Correlations of Detrended Solow Residuals (1970 - 1984):

Country United States Aggregate Traded Nontraded Canada Aggregate Traded Nontraded Japan Aggregate Traded Nontraded Germany Aggregate Traded Nontraded Canada Japan Germany Italy

Table 1 shows the cross-country correlations of growth rates of output: the top number in each element of the table shows the correlation between aggregate output in the two countries, the middle number shows the cross-country correlation between tradedgood outputs, and the lower number shows the correlation between nontraded-good outputs. The correlations between aggregate outputs are positive and range from 0.44 between Canada and Japan to 0.86 between the United States and Germany, with an average of 0.64. The sectoral corre-

lations are slightly lower on average than the aggregate correlations. Second, Solow residuals are positively correlated across countries, but are less positively correlated than outputs (see also Donna Costello, 1993). The Solow residuals for each sector i ( i = aggregate, traded, or nontraded) are:

where a' is the labor share in each sector, and output, capital, and labor are de-

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TABLE1- Continued

C. Correlations o f Detrended Consumution: Pricate Final, Traded and Nontraded (1970 - 1989):" Country
-

Canada

France

Japan

United IGngdom

United States
PFC
Traded
Nontraded
Canada
PFC
Traded
Nontraded
France
PFC
Traded
Nontraded
Japan
PFC
Traded
Nontraded

Notes: The Solow residuals are calculated from detrended capital, labor, and output. Output of traded goods includes the agricultural, manufacturing, mining, retail, and transportation sectors; nontraded-good output includes electricity, gas, and water, construction, finance, insurance and real estate, and private and government services. In part C, PFC = private final consumption. Traded-good consumption is consumption of nondurables; nontraded-good consumption is consumption of services. All data are detrended using the Hodrick-Prescott filter. Sources: Data for parts A and B are taken from the OECD International Sectoral Data Base. Part C is based on data from the OECD Quarterly Accounts that are annualized by averaging.

Part B of Table 1 reports trended cross-country correlations of Solow residuals. The Solow residuals are generally positively correlated but are notably smaller than the output correlations for all pairs of countries except between the United States and

4 ~ v e r a g le abor shares estimated from aggregate output, capital, and employment data range from 0.50 for Italy to 0.65 for Canada. Interestingly, for five of the seven countries, the traded-good sector appears to be more labor-intensive than the nontraded-good sector. Italy and Japan have the lowest labor shares in both industries, while the United States and the United Kingdom have the highest labor shares. The data used are from the OECD intersectoral data base. For a complete presentation of these estimates see Table 3 in Stockman and Tesar (1990). ' w e detrend output, capital, and labor to insure that the Solow residuals are stationary. Our model is not intended to explain growth; therefore, we focus on deviations from the long-run growth path in the model and in our empirical work.

Canada. The average cross-country correlation of aggregate Solow residuals is 0.33, compared to 0.64 for output. The average cross-country correlation of Solow residuals for the traded and nontraded sectors of the economy are 0.28 and 0.25, while the corresponding average output correlations are 0.56 and 0.58. This evidence casts doubt on t h e view that positively correlated Solow residuals are the sole explanation for international comovements of output. It suggests either that other exogenous disturbances help create the stronger cross-country correlation of output or that a model must endogenously amplify the effects of the underlying disturbances to productivity. Third, the cross-country correlations of consumption are positive and are roughly the same size as the cross-country correlations of output. Part C of Table 1 reports cross-country correlations of private final consumption (PFC) and consumption of

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traded and nontraded goods based on the data reported by the O E C D . ~The correlation between private final consumption ranges from 0.26 between the United Kingdom and Japan to 0.82 between Canada and France; the average is 0.53. The crosscountry correlation between consumptions of nontraded goods is slightly smaller on average (0.44) than that between consumptions of traded goods (0.47), though on a country-by-country basis this ordering is sometimes reversed. The low cross-country correlations of consumption pose a problem for two-country neoclassical models which assume that financial markets are well integrated. In many such models (with complete markets and without distortions), consumption is perfectly (or nearly perfectly) correlated across countries. Backus et al. (1992) and Michael B. Devereux et al. (1992) study a one-sector, two-country model in which consumption is imperfectly correlated across countries because leisure and consumption are substitutes in utility. In this setting, a persistent productivity shock in the home country raises the domestic marginal product of labor and reduces leisure. Because leisure and consumption are substitutes, equilibrium consumption in the home country rises more than in the foreign country (or falls less), breaking the close link between foreign and domestic consumption. This is only one of several mechanisms that break the link between home and foreign consumption in our model. The low consumption correlations are related to the much-discussed positive relation between national saving and investment (Martin S. Feldstein and Charles Horioka, 1980; Tesar, 1991; Baxter and Crucini, 1993). As shown in the first column
6 ~ Part C of Table 1, the top figure in each cell is n the cross-country correlation for private final consumption, the second is that for consumption of traded goods, and the third is that for consumption of nontraded goods. We use consumption of services as a proxy for consumption of nontraded goods and consumption of nondurables as a proxy for traded goods. Private final consumption is the sum of services and nondurables. These definitions of traded and nontraded goods are described in more detail in what follows.

of Table 2 the correlation between savings and investment ranges from 0.43 in Italy to 0.90 in Canada. In the same set of countries, the correlations between the tradebalance surplus and output are negative for all countries except France. The five-country average is -0.33.' We define the trade balance as detrended exports minus detrended imports, rather than the detrended difference:' (2) TB, = EXP, - IMP,.

This definition allows us to calculate the growth rates of the trade balance; we can then study the sensitivity of our results to the method of detrending. When the growth-rate filter is used, the correlation between the trade balance and output ranges from - 0.38 to 0.06, with a fivecountry average of - 0.25. A countercyclical trade balance may seem to contradict the implications of a model based on productivity shocks. In the case of purely temporary changes in productivity, consumption-smoothing would suggest that the country with high productivity will increase its net exports. However, persistent shocks raise the marginal product of capital, which increases investment in the highproductivity country. If the increase in investment exceeds the increase in output, then the country with a positive productivity shock initially reduces its net exports. Eventually, as the exogenous disturbance dies out, the country's net investment falls and its net exports rise. In our model, the presence of nontraded goods also contributes to a countercyclical trade balance. If there is some complementarity between traded and nontraded goods, an increase in the output of the nontraded good in the home country will increase consumption of the nontraded good, and this will in turn lead to an increase in demand for the traded good (see Tesar, 1993).

' ~ h e s e correlations are virtually unchanged when the sample period includes the 1960's. %e employ this definition of the trade balance in the data and the model.

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TABLE 2-CORRELATIONS AND STANDARD DEVIATIONS ~NTERNATIONALVARIABLES OF Correlations Country Canada France Italy United Kingdom United States (S, I ) 0.90 0.87 0.43 0.63 0.89 (TB,Y) Standard deviations TOT 3.94 5.83 6.91 5.43 6.19 TB 5.41 4.31 8.44 6.96 8.02

- 0.71 0.21 - 0.26 - 0.52 - 0.39

Notes: Columns 1. 2. and 4 are annual data from International Financial Statistics (IFS). These data cover the period 1970-1988 with the exception of Italy which covers 1970-1987. Savings is GNP less aggregate consumption. Savings for France is GDP less aggregate consumption as annual GNP data were unavailable from IFS. Termsof-trade data in column 3 are taken from OECD Main Economic Indicators and cover the period 1970-1987. The terms of trade are the ratios of the import deflator to the export deflator. The trade balance is detrended exports less detrended imports. All series are detrended using the Hodrick-Prescott filter.

Columns 3 and 4 of Table 2 report the standard deviations of the terms of trade and the trade balance. These figures generally exceed the standard deviation of output, and we will find that they are much larger than the values generated by our modeL9 This appears to be a problem for real-business-cycle models in general and remains a puzzle for future research. B. Empirical Regularities Within Countries Perhaps the most striking feature of the data of the seven industrialized countries is the large share of nontraded goods in the economy. Following Irving Kravis et al. (1982) as closely as possible, we categorize the ten sectors reported by the OECD Intersectoral Data Base into traded and nontraded industries. We include agriculture, manufacturing, mining, retail, and transportation in the traded-good sector and electricity, gas, and water, construction, finance, insurance and real estate, and private and government services in the nontraded-good sector.1 Under this decompo-

sition, nontraded goods account for about half of output in each of the countries." This corresponds closely to the share of 52 percent reported by Kravis et al. (1982 p. 194 [table 6-10]) for their ten-country sample of industrialized countries. The share of nontraded goods in private final consumption ranges from roughly 30 percent to 50 percent depending on the method used for classifying traded and nontraded consumption goods.'' We use two methods of decomposing private final consumption into these categories. The first method treats services and nontraded goods as equivalent. The second measure is based on a breakdown of private consumption ex-

'1n Stockman and Tesar (19901, we examine the correlations of the terms of trade with output and the trade balance. We find that it is difficult to draw conclusions about the cyclical behavior of the terms of trade and the real exchange rate in either HodrickPrescott-filtered data or first-differenced data. "See Stockman and Tesar (1990 table 7) for the shares of each of the industries in GDP. These shares are remarkably similar across countries.

"A good case can be made that most retail services (retail and wholesale trade and services of restaurants and hotels) should be considered nontraded goods. We include value added of retail and wholesale trade in the traded-good category to be consistent with Kravis et al. (1982). However, they do treat restaurants and hotels as nontraded goods. They are included in our measure of traded goods because the data are not reported for all countries, and the share of restaurants and hotels in total GDP is small enough (less than 3 percent of GDP) that this should have little effect on the overall results. Kravis et al. (1982) also treat public transportation and communication as nontraded goods. We treat them as traded goods because we lack data to separate these categories from private automobile purchases, which are the largest component of the transportation category. 12see Stockman and Tesar (1990, table 9) for the exact shares in each country.

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penditure by type, following as closely as possible the decomposition specified by Kravis et al. (1982). When services are used as a proxy, the data indicate that nontradables are a large and growing component of consumption, while the second measure of nontradables indicates a share closer to one-third.13 The second measure is a smaller number because several of the categories considered by Kravis et al. (1982) to be nontradables are not reported by the O E C D . ' ~ , 'Given the lack of complete time ~ series in each category, we will use services as a proxy for consumption of nontradables in the remainder of our analysis. The large proportion of nontraded consumption and output in the economy is consistent with the relative importance of trade in the industrialized countries. On average, trade is about 20 percent of aggregate output, where trade is measured as the average of exports plus imports. In contrast, a simple model in the tradition of Robert E. Lucas, Jr. (1982), abstracting from nontradables, would predict that trade is half of output. Table 3 shows the standard deviations of output, Solow residuals, the capital stock, work effort, investment and consumption in each sector. The standard deviations of the

Solow residuals in each industry are approximately the same magnitude as the standard deviations of output in that industry and are higher in the traded sector than in the nontraded sector. Investment is 2-3 times as variable as output in most countries and in other industries, while labor is uniformly less variable than output. The last column of Table 3 lists the standard deviations of private final consumption and consumption of traded and nontraded goods. Private final consumption is generally less volatile than consumption by sector. The inclusion of nontraded goods in our model allows us to consider the comovements of variables across sectors and the relationships between prices and quantities. Table 4 shows some results that will play an important role in the conclusions we will draw about the sources of shocks. The third column of Table 4 shows the correlations between the relative price of nontraded goods and the ratio of consumption of nontraded to traded goods. The correlation is negative in four of the six countries with an average of - 0.22.'~Replication of this correlation will prove to be a problem for the model based on productivity shocks alone: in the theoretical model, an increase in productivity causes an increase in consumption of the good and a large fall in its relative price, resulting in a correlation of - 1.
11. A Two-Sector, Two-Country Model

130ne problem with using services as a proxy for nontradables is that trade in some tyDes of services has been increasing. In the United s t a t i s there is evidence that trade in services has expanded at a rate faster than the growth in output of services. However, most services were generally nontraded in the sample covered by this paper. 1 4 ~ h second measure of nontradables includes the e categories "rent, fuel and power" and "transportation and communication" reported by the OECD. T o the extent that transportation includes the purchase of automobiles, inclusion of this category clearly overstates the importance of nontradables in private consumption. However, since the other categories included in the Kravis et al. (1982) definition of nontradables are unavailable, we believe the overall figure underestimates, rather than overestimates, the share of nontradables in consumption. 15 The two measures are comparable for the United States when CITIBASE data (which include a more detailed decomposition of consumption data than the OECD) is used (see table 9 of Stockman and Tesar [1990]).

In this section we describe our twotwo-country Our research builds on the work in several recent Papers on international real business cycles (Harris Dellas, 1986; Don E. Schlagenhauf, 1989; Mendoza, 1991; Backus et al., 1992; Shaghil Ahmed et a1.7 1993; Baxter and Crucini, 1993). The model is based on Lucas (1982), extended to included nontraded goods following stockman and ~ ~ l and l adds production and investment that model. Each country specializes in the Pro-

1 6 ~ h corresponding number using the growth-rate

e filter is -0.23.

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Country Canada
Aggregate
Traded
Nontraded
France
Aggregate
Traded
Nontraded
Germany
Aggregate
Traded
Nontraded
Italy
Aggregate
Traded
Nontraded
Japan
Aggregate
Traded
Nontraded
United Kingdom
Aggregate
Traded
Nontraded
United States
Aggregate
Traded
Nontraded

Output Solow residual Capital Labor Investment Consumption

Notes: Columns 1-5 are based on the OECD International Sectoral Data Base. Standard deviations are calculated over the period from 1970 to the last available observation, which varies from 1984 to 1986 depending on the country and the sector. Solow residuals are estimated from detrended capital, labor, and output data. Consumption data in column 6 are from the OECD Quarterly Accounts and are annualized by averaging. The category aggregate consumption in the table corresponds to private final consumption. Consumption data cover the period 1968-1991 for Canada, the United States, and the United Kingdom; 1970-1991 for France; 1980-1990 for Italy; and 1970-1989 for Japan. All series are detrended using the Hodrick-Prescott filter.

duction of a tradable and nontradable good. Each good is used for consumption and investment in its own sector. We calibrate the model to an "average" industrialized country in order to capture the dynamic interactions between two similar industrial- ized economies."

Output in each industry is

17 We plan to focus on the differences across countries in future work; we abstract from these differences here.

where i E (T,NT, T*,NT*) with T and NT denoting traded and nontraded goods and asterisks denoting foreign variables. The term K' is industry-specific capital (consisting of goods from that sector), N' is labor in industry i, and A' is a disturbance to total factor productivity. The economy grows at a constant rate of y through labor-augmenting technical

THE AMERICAN ECONOMIC REVIEW

TABLE4-CORRELATIONSBETWEEN PRICESAND QUANTITIES Country Canada France Germany Italy Japan United Kingdom United States 0.27 0.70 n.a. 0.83 0.80 0.10 0.69 0.62 0.83 0.61 0.86 0.49 0.91 1.OO
- 0.72 -0.13 n.a. -0.14 0.39 0.17 - 0.86

MARCH 1995

0.44 0.20 0.50 0.04 0.03 0.20 0.54

Notes: Consumption data in columns 1 and 3 are from OECD Quarterly Accounts and are annualized by averaging. Data cover the periods 1968-1991 for Canada, the United Kingdom, and the United States; 1970-1991 for France; 1980-1990 for Italy; and 1970-1989 for Japan. Output data in columns 2 and 4 are from the OECD Intersectoral Data Base. These series cover the periods 1970-1986 for Canada, Japan, the United Kingdom, and the United States; 1970-1984 for France; and 1970-1985 for Germany and Italy. All series are detrended using the Hodrick-Prescott filter.

progress; we assume that the productivity shocks are transitory deviations from this steady-state growth path. Capital depreciates at a rate of 6, so capital and investment are related by

lifetime utility subject to a wealth constraint:18

XI

(6) PIE,

f =O

C u ( c l t ,c z t ,d t , Lr)

Labor is mobile between the traded-good and nontraded-good sectors. We normalize each country's population and the endowment of time of the representative household in each country at 1, so the labor constraint is

(5)

N,T + N

~ L~= 1.~ ~

In a similar way, the representative consumer in the foreign country chooses plans for {c?,c;, d*, L*} to maximize lifetime utility subject to its wealth constraint. In equilibrium, world output of each traded good must equal world consumption and investment of that good. Output of each nontraded good must equal consumption plus investment of that good within the

The foreign country has an identical econ0mic structure. ~h~ representative household in the home country derives utility from consumpt~onof the traded good produced firms (c,), the traded good produced by foreign firms (c,), the nontraded good (d), and leisure (L), date t , the household chooses a lifetime (contingent) plan of and work effort to maximize its expected

18We assume that the household faces a complete contingent-claims market. More specifically, contracts can be written contingent on outcomes in both the traded- and nontraded-good industries, which allows the household to insure partially against fluctuations in leisure and in the local supply of nontraded goods. The household's wealth constraint has the obvious form for complete contingent markets. Rather than solve for the competitive equilibrium directly, we solve a social planning problem corresponding to the competitive equilibrium in which the countries are assumed to have equal expected wealth.

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country. This implies

for the sequences of prices and capital stocks that are consistent with the transversality conditions.
111. Calibration of the Model and Results

We estimate parameters consistent with the steady-state behavior of an "average" and industrialized country to compare our model with the evidence discussed in Section I. To capture the dynamics of these economies, we calculate the Solow residuals for the five countries (Canada, Germany, Italy, Japan, We solve for the equilibrium allocations and the United States) for which sectoral of consumption, leisure, work effort, and data on output, labor, and capital were capital inputs by considering the problem available in the 1970-1986 period.19 We facing a social planner who maximizes the then use the properties of these estimated expected lifetime utilities of the two repreSolow residuals to solve the model numerisentative agents. The planner chooses concally. sumption and investment of each good to Table 5 summarizes the parameter valmaximize ues. We calibrate the model to moments of annual data. The growth rate of aggregate output is 2.73 percent per annum, the average trend growth of our five-country sample in the period 1970-1985.20 The depreciation rate of capital is set equal to 10 percent per annum. The production parameter a' is subject to equations (3145) and (7)-(10). set equal to the average labor share in the We abstract from differences in country size seven countries. We equate the steady-state or wealth by setting w equal to 0.5. values of outputs of the two industries so that nontraded goods comprise half of outThe disturbances to technology are asput. These restrictions imply a steady-state sumed to follow an AR(1) process: allocation of work effort of 52.1 percent to the traded-good industry and 47.9 percent A,,, = R A , E , ( 12) to the nontraded-good industry. Following Kravis and Robert E. Lipsey where A is the vector [AT,ANT,AT*,ANT*] (1987 p. 130 [footnote 1211, we estimate the and R is a 4 x 4 matrix describing the auelasticity of substitution between traded and toregressive component of the disturbance. The innovation to A is [ E ~ , E ~ ~ , E ~ * , nontraded . goods from the cross-sectional E~~*] data provided in the World Bank's Income The covariances between the elements of E reflect the extent to which the shocks are common to industries or countries or are global in nature. We solve for the nonstochastic steady 191n calculating our cross-country averages, we use state of the model and approximate the the largest number of countries for which data are dynamics of the model in response to exogeavailable. As seen in Table 3, sectoral production data nous shocks by linearizing the first-order are available for five of the seven countries, and consumption data are available for six of the seven. conditions around the steady state, as de20This is the average of the trend components for scribed in Robert G. King et al. (1988). This the five countries when the trend is calculated with the yields a system of first-order difference Hodrick-Prescott filter. The average annual growth rate equations in the capital stocks and the exfor the five countries is 3.07 when calculated from ogenous disturbances; we solve this system first-differenced data.

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MARCH 1995

Parameter Technology: y = 2.73 6 = 0.10 sT( = sNT)= 0.5 aT= 0.61 aNT 0.56 = vT = 0.521 vNT = 0.479 Preferences: w = 0.5 p = 0.96 l/u = 0.5 1/(1+ /.L) = 0.44 0 = 0.5 l/a = - 0.315

Definition Rate of technical progress (percent per annum) Depreciation rate Share of production of traded (and nontraded) goods in total output Labor share in traded-good industry Labor share in nontraded-good industry Share of work effort allocated to traded-good production Share of work effort allocated to nontraded-good production Home country's share of world wealth Rate of time preference Intertemporal elasticity of substitution Elasticity of substitution between traded and nontraded goods Share of domestically produced goods in consumer's bundle of traded goods Intertemporal elasticity of substitution in leisure

Comparison ~ r o j e c t . ~ ' find that there is We a low degree of substitution in consumption with an elasticity of substitution [1/(1+ p ) ] of 0.44.22 We set the rate of time discount equal to 0.96, the intertemporal elasticity of substitution ( l / a ) to 0.5,23 and the

21 We calculate the elasticity of substitution between traded and nontraded goods in a sample of 30 countries using data on per capital G D P (Kravis et al., 1982 p. 12). expenditure shares on traded and nontraded goods (Kravis et al., 1982 p. 1941, and price indexes for traded and nontraded goods (Kravis et al., 1982 p. 196). T o find we regress the nontraded-good expenditure share on the price index for nontraded goods and include per capita G D P to pick up income effects. 2 2 ~ use the full set of countries to estimate this e elasticity of substitution. Jonathan Ostry and Carmen Reinhart (1991) use generalized-method-of-moments techniques to jointly estimate the elasticity of substitution between traded and nontraded goods and the intertemporal elasticity of substitution in 13 developing countries. They find evidence that the elasticity of substitution between the two types of goods is significantly higher for developing countries than for industrialized countries. Mendoza (1991) repeats our regression for industrialized countries only and finds that the elasticity is 0.74, higher than our estimate but still below unity. For a detailed discussion of the interconnection between I*, and u in a two-country model with nontraded goods, see Tesar (1993). 23 Different values of a result in the expected changes in aggregate consumption and investment behavior but have little impact on the features of the data studied here.

intertemporal elasticity of substitution in leisure (l/a) to -0.315, which is consistent with a steady-state allocation of 20 percent of the time endowment to work effort and 80 percent to leisure. These parameters determine the steady-state shares of consumption and investment in output of the two goods. The remaining parameter to be chosen is the share of domestic goods in the domestic consumer's total consumption bundle. This share is difficult to estimate directly from the data; however, under the assumption of complete specialization in traded-good production, the share can be inferred from data on trade flows between the industrialized countries. Total consumption is approximately 80 percent of GDP; since nontraded goods make up about half of output, consumption of nontraded goods is roughly 40 percent of GDP. With perfect pooling of traded-good consumption, this implies that trade is 20 percent of GDP, which is consistent with the average in our sample of countries. The volume of trade implied by our model is Trade GDP
1

(13)

--

- -e(l-

ST)

where "trade" is defined as the average of

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exports plus imports and is the investment share in total output of the domestic traded good. We set 13 equal to 0.5, which implies that each country consumes a bundle of traded goods made up of equal shares of domestic and foreign goods. The implied volume of trade is 0.188, very close to the observed volume of trade of 20 percent in the largest OECD countries.24 The technology shocks to the two industries display a low degree of persistence when calculated from Hodrick-Prescottfiltered data.25 The estimated autocorrelation matrix for the vector of shocks [AT,ANT,AT*,ANT*]is

ST

The degree of autocorrelation is low, especially in the traded-good industry. The estimated variance-covariance matrix of the shocks is

The variance of the productivity shocks is nearly twice as high in the traded-good industry as in the nontraded-good industry.

24 Our model does not address the fact that the share of trade in GDP has been growing over time in most countries, but treats the volume of trade in output as a constant. However, our model does suggest that in the presence of nontraded goods and specialized production, the long-run share of trade in output is likely to level off at a number significantly less than 0.5. 2 5 ~ h eestimated autocorrelation and variancecovariance matrices based on data that are detrended using the growth-rate filter are available from the authors upon request.

The correlation between innovations to the traded-good sectors is 0.33, while the correlation between innovations to the nontraded-good sectors is 0.14. Country-specific innovations (across sectors within a country) are slightly larger, with a cross-sector correlation of 0.46. Table 6 compares the quantitative implications of the model with the data. The top portion of the table shows standard deviations of aggregate and sector-level output, labor, investment, and consumption; the lower part of the table shows various crosssector and international correlations and the standard deviations of the terms of trade (TOT) and trade balance (TB). The numbers in the "data" column are five-country averages of the standard deviations or correlations presented in the tables in Section 11, followed by a centered two-standarddeviation range in parentheses which summarizes the extent of variation across the countries in our sample.26 For example, the first row of Table 6 shows that the average standard deviation of aggregate output (from Table 3) is 2.53 percent per year, and the estimated standard deviation of that average is 0.53 percent, giving a twostandard-deviation range for the standard deviation of aggregate output of 2.00 percent to 3.06 percent per year. The column labeled "technology shocks only" shows the implications of the model driven by technology shocks as measured by Solow residuals. The model produces a standard deviation of aggregate output of 2.58 percent per year, which matches the data fairly closely. (We discuss the final column of Table 6 in the following section.) Table 6 shows that the model driven by technology shocks replicates the standard deviations of output, labor, investment, and consumption fairly closely. Two exceptions are that the model overpredicts the standard deviation of investment in the tradedgoods sector by 30 percent, and it overpredicts output in the nontraded-goods sector

his range ignores sampling error in estimating the moments reported in earlier tables.

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Variable Standard deviation, aggregate: Output Labor Investment Consumption Standard deviation, traded-good sector: Output Labor Investment Consumption Standard deviation, nontraded-good sector: Output Labor Investment Consumption Domestic correlations: Corr(C, Y) Corr(I,Y) c o r r ( c T , CNT) ~ o r rT,Y~ ( NT) Domestic price-quantity correlations: c o r r ( p N TpT cNT )
cT corr(p~$p': YN$YT)
International variables, correlations: Corr(Y, Y * ) Corr(C,C*) corr(cT,c T " ) Cords, I ) Corr(TB, Y) International variables, standard deviations: s.d.(TOT) s.d.(TB)

Data

Technology shocks only

Taste shocks

Notes: The figures in the "Data" column are cross-country averages of the moments and correlations reported in Tables 1-4. The figures in parentheses are the two-standard-deviation range around the cross-country average. These numbers are based on the following data: standard deviations of output, labor, and investment by sector are five-country averages of the figures in Table 3; standard deviations of consumption are six-country averages of the consumption figures in Table 3. The correlations between consumption (C), investment ( I ) , and output (Y) are based on IFS data for the seven countries. One observation on the correlation between aggregate consumption and output was dropped as it appeared to be an outlier. The correlations between consumption and output across sectors and the price-quantity correlations are cross-country averages of the figures in Table 4. The cross-country correlations of aggregate and traded-good consumption and aggregate output are averages of the figures in Table 1. The correlations between savings (S) and investment and the correlations between output and the trade balance are averages of the figures in Table 2. France is dropped from the output-trade-balance correlation as it appeared to be an outlier. The standard deviations of the terms of trade and the trade balance are five-country averages of the figures in Table 2.

by 40 percent2' The success of the model in matching correlations, however, is mixed.

''An earlier draft of this paper included durable goods in traded-good consumption, and the resulting standard deviation of consumption was much higher than the level predicted by the model. This result conflicted with the usual finding that consumption is "too smooth" empirically (see e.g., John Campbell and

The model replicates exactly the correlation of 0.64 between home and foreign output. It overstates somewhat the cross-country correlation of aggregate consumption and,
Angus Deaton, 1989). We thank John Campbell and the referees for (among other things) convincing us to exclude durable and semidurable goods from consumption.

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more importantly, greatly overstates the cross-country correlation of consumption of traded goods. (Interestingly, the data show that the cross-country correlation of consumption of traded goods is less than that of aggregate consumption.) The intuition for the high correlation between consumption of traded goods in the two countries is straightforward. The model would imply perfect correlation between traded-good consumption across countries except for two nonseparabilities in utility. First, the marginal utility of consumption of traded goods is not independent of leisure, so variations in labor effort that differ across countries (in response to technology shocks that cause international differences in the marginal product of labor) lead to crosscountry differences in consumption of traded goods. This effect, however, is relatively small. Second, traded and nontraded goods do not enter utility in an additively separable way, so variations in consumption of nontraded goods, brought about by productivity shocks in the nontraded sector, affect the marginal utility of traded goods. The cross-country correlation of nontraded-sector technology shocks implied by the variance-covariance matrix in equation (15) is only 0.14, so the near-independence of these shocks creates cross-country differences in nontraded-good consumption, and complementarity between consumption of traded and nontraded goods creates cross-country differences in traded-good c o n ~ u m p t i o n .But this effect is also small ~~ (partly because productivity shocks to the nontraded sector are smaller than those to the traded-good sector; the variance of the former is about half the latter). The combined effect of these two nonseparabilities (with leisure and with consumption of nontraded goods) leaves the cross-country correlation of traded-good consumption implied by the model at 0.94. At the same time, the near-independent technology

shocks to the nontraded sector reduce the cross-country correlation of aggregate consumption to 0.78 in the model. The model matches fairly closely the correlations between savings and investment, between the trade balance and output, and between consumption and output. It slightly overpredicts the correlation between investment and output. The predicted correlation between consumption of traded and nontraded goods is within the two-standarddeviation range of the data. However, it is 50 percent above the correlation observed in the data. The opposite is true of the correlation of output across sectors. To summarize, the three largest discrepancies between the data and the predictions of the model are:

1. The model significantly overpredicts the cross-country correlation of consumption, particularly the cross-country correlation of consumption of (composite) traded goods. This problem is not unique to our model; it is a fairly general feature in previous work (e.g., Backus et al., 1992). Table 6 shows that incorporating nontraded goods into the model does not eliminate this problem. In particular, the model is missing some source of nationspecific variation in consumption of traded goods. 2. The model implies a correlation of - 1 between the relative price of nontraded goods and relative consumption of nontraded to traded goods, while the crosscountry average of the correlation is only -0.22. The problem occurs because technology shocks act mainly as relative supply shocks, shifting supply curves (or the production possibilities frontier) along stable demand curves (a stable indifference map), generating a high negative correlation between relative prices and relative consumption bundles.29 The same problem shows up in the correla-

28 The goods are complements in that the elasticity of substitution in consumption (0.44) is less than 1, using the Kravis and Lipsey (1987) estimate.

2yThe linearization involved in solving the model produces essentially linear demand curves, resulting in a perfect (negative) linear correlation.

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tion between the relative price and relative outputs of nontraded and traded goods. Clearly, no small change in the structure of the model can change this counterfactual feature as long as the model is driven by technology shocks alone. The model is missing a source of underlying shocks that shift relatice demand~.~' 3. The model grossly understates the standard deviation of the balance of trade and the terms of trade. The former is nearly 15 times too small. It seems clear that these data cannot be explained by a model based on technology shocks alone. The key element missing from this (and previous) models is a source of nation-specific shocks that shift demands. This leads us to consider the effects of small taste shocks.
IV. Taste and Tech~iologyShocks

We add taste shocks to our model by including disturbances to the utility function of the following form:

where T, (for i = 1,2) is a positive random variable with mean 1. There are two analogous taste shocks for the foreign household. We measure taste shocks in three ways. First, we assume that taste shocks are aggregate disturbances to utility at each date t (i.e., that = T2t in each period). We then calculate the implied aggregate taste shocks from the condition that equates the intertemporal marginal rate of substitution

of the (composite) traded good across countries. To identify the shocks from the data, we assume that the disturbances are uncorrelated across countries and that labor supply is fixed. We find that the shocks measured under this set of assumptions are very large, with a variance roughly 2.5 times that of the variance of the shocks to p r o d ~ c t i v i t y .The primary effect of these ~~ demand shocks in our model is to double the standard deviation of consumption, even when the shocks are transitory.32 The standard deviations of output, investment, and labor supply also increase, and the crosscountry consumption correlation falls. Because the shocks have no impact on the demand for nontraded goods relative to traded goods, it is not surprising that this form of demand disturbance does not explain the comovements between relative prices and quantities. Next, we measure tastes shocks from the relative demands for traded and nontraded goods. We set T 2 r = T ; ~ = 1 and calculate the time series of the relative preference shocks { T , ~ ) implied by equating the T:,, marginal rate of substitution between traded and nontraded goods with the relative price of nontraded goods. We find that taste shocks measured in this way are extremely small, with a standard deviation one-tenth that of technology shocks. Incorporation of these shocks has virtually no effect; the results are nearly identical to those in Table 6 with technology shocks alone. Our third approach is to consider tastes shocks of an intermediate size. We assume that the standard deviation of T, is 1.63 in each country, which is roughly 85 percent of the size of productivity shocks in the traded-good sector and reproduces the standard deviation of traded-good consumption in our model. We assume that the standard deviation of T~ is zero. The autocorrelation

"'This could be generated by shocks to the marginal-rate-of-substitution function, or to something such as taxes, which drive a wedge between the marginal rate of substitution and the relative price.

"Under complete contingent claims, the marginal utilities of the (composite) traded good are equalized across countries at all dates. The variability of taste shocks implied by this condition is even larger than those based o n the intertemporal Euler equations. 3 2 ~ hstandard deviation of consumption rises even e further if the shocks are persistent.

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of the taste shocks is assumed to be the same as the autocorrelation of technology shocks, which for the traded sector is 0.15. Table 6 shows that the model driven by shocks to both tastes and technology is now consistent with most features of the data. It generates cross-country correlations for both aggregate and traded-good consumption that are similar to those in the data. It implies that the correlation between the relative price of nontraded goods and relative consumption of those goods is - $, which is about one standard deviation awav from the five-country average and well above the - 1 correlation implied by the model without taste shocks. Finally, taste shocks raise the standard deviation of the trade balance by a factor of five, bringing its value much closer to the cross-country average. Taste shocks also reduce the correlation between consumption of traded and nontraded goods, bringing the results into greater conformity with the data. The only dimension in which the correspondence between the model and the data noticeably deteriorates is in the correlation between the trade balance and outuut. This is likely to be a result of our siiplifying assumption that the traded-good industry in each country uses only domestically produced capital in production. Modifying this assumption would likely move the correlation more in conformity with the evidence because a positive technology shock in the home country would lead to increased imports of investment goods at the same time outuut rises. This or some other modificatioi of the model might result in its being more consistent with the countercyclical nature of the trade balance. But no small modifications of the basic model other than introducing taste shocks, or other shocks that operate in much the same way, would be likely to explain the observed patterns in consumption and relative prices.
V. Conclusions

this assumption to have important consequences; relaxing it worsens the match between the implications of the model and the data. In addition, open-economy extensions of these models have not previously been successful in accounting for observed crosscountry correlations of output and consumption. This paper studies the question of whether these problems result from ignoring the evidence that about half of output consists of nontraded goods. We find that accounting for nontraded goods is important but does not resolve all the difficulties in replicating the data. Instead, the evidence suggests that technology shocks are unable to explain the main features of the data on international comovements in output and consumption and related time series. We briefly explore taste shocks (or household-productivity shocks) as this additional source of disturbances. Although we focus on a very simple form of shocks to preferences, this simple combination of shocks to tastes and technologies does a reasonably good job in matching the data on both aggregate and sectoral variability and international comovements of output and consumption. Future research should focus on alternative sources of demand shocks and on explanations for the large variation of the terms of trade. Since some theoretical models of exchange rates suggest that real disturbances like those emphasized in this paper are the main cause of changes in real (and nominal) exchange rates, further work along these lines would help provide the foundations for a quantitative analysis of neoclassical international finance that integrates equilibrium models of real exchange rates with neoclassical models of business cycles and their international transmission.

Closed-economy real-business-cycle models implicitly impose an ad hoc assumption: that nations cannot trade goods and assets internationally. Previous research has shown

The International Sectoral Data Base (ISDB) compiled by the OECD provides time series on output, employment, investment, capital stocks, and factor payments by sector in 13 OECD countries. The sector classification is based on the international standard industrial classifications (ISIC). Gross capital stocks are estimated from investment data allowing for varying rates of depreciation across countries and across

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sectors. For a detailed discussion of the estimation procedure, see F. J. M. Meyer-zu-Schloctern (1988 pp. 2-6). W e construct time series for productivity growth in the traded and nontraded industries from constant-price, domestic-currency-denominated series of capital, output, and compensation of employees and the total number of employees. We take consumption data from the OECD Quarterly National Accounts. W e decompose private final consumption of commodities by type (durables, semidurables, nondurables, and services) and by object (food, beverages, and tobacco: clothing and footwear: gross rent, fuel, and power; transport and communication; furniture and household operations; and other goods and services). We use two proxies for consumption of nontradables: "services" from the classification by type, and "gross rent, fuel, and power" plus "transport and communication" from the classification by object. U.S. data for these categories are taken from CITIBASE. We construct the relative prices of nontradables in each country from the price deflators of the service and nonservice components of consumption. Deseasonalized quarterly data from O E C D are annualized by averaging. We take data on aggregate output, investment, savings, net foreign investment, exports, and imports from International Financial Statistics published by the IMF. We deflate production using the GNP (GDP) deflator and consumption data using the CPI. In some cases, data for the United States are taken from CITIBASE. The export- and import-price deflators used to calculate the terms of trade are taken from the OECD Maln Econom~cIndicators.

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Campbell, John and Deaton, Angus. "Why Is

Consumption So Smooth?" Reciew of Economic Studies, July 1989, 56(3), pp. 357-74. Costello, Donna. "A Cross-Country, CrossIndustry Comparison of Productivity Growth." Journal of Political Economy, April 1993, 101(2), pp. 207-22. Dellas, Harris. "A Real Model of the World Business Cycle." Journal of International Money and Finance, September 1986, 5(3), pp. 381-94.
Devereux, Michael B.; Gregory, Allan W. and Smith, Gregor W. "Realistic Cross-Country

Consumption Correlations in a TwoCountry, Equilibrium, Business Cycle Model." Journal of International Money and Finance, February 1992, 11(1), pp. 3-16.
Feldstein, Martin S. and Horioka, Charles.

"Domestic Saving and International Capital Flows." Economic Journal, June 1980, 90(358), pp. 314-29.
King, Robert G.; Plosser, Charles I. and Rebelo, Sergio T. "Production, Growth and Busi-

ness Cycles, I: The Basic Neoclassical Model." Journal of Monetary Economics, March/May 1988, 21(2/3), pp. 195-232.
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Homework in Macroeconomics: Household Production and Aggregate Fluctuations Jess Benhabib; Richard Rogerson; Randall Wright The Journal of Political Economy, Vol. 99, No. 6. (Dec., 1991), pp. 1166-1187.
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Real Business Cycles in a Small Open Economy Enrique G. Mendoza The American Economic Review, Vol. 81, No. 4. (Sep., 1991), pp. 797-818.
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Why is Consumption So Smooth? John Campbell; Angus Deaton The Review of Economic Studies, Vol. 56, No. 3. (Jul., 1989), pp. 357-373.
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International Real Business Cycles David K. Backus; Patrick J. Kehoe; Finn E. Kydland The Journal of Political Economy, Vol. 100, No. 4. (Aug., 1992), pp. 745-775.
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Explaining Saving--Investment Correlations Marianne Baxter; Mario J. Crucini The American Economic Review, Vol. 83, No. 3. (Jun., 1993), pp. 416-436.
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Homework in Macroeconomics: Household Production and Aggregate Fluctuations Jess Benhabib; Richard Rogerson; Randall Wright The Journal of Political Economy, Vol. 99, No. 6. (Dec., 1991), pp. 1166-1187.
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Why is Consumption So Smooth? John Campbell; Angus Deaton The Review of Economic Studies, Vol. 56, No. 3. (Jul., 1989), pp. 357-373.
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A Cross-Country, Cross-Industry Comparison of Productivity Growth Donna M. Costello The Journal of Political Economy, Vol. 101, No. 2. (Apr., 1993), pp. 207-222.
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Domestic Saving and International Capital Flows Martin Feldstein; Charles Horioka The Economic Journal, Vol. 90, No. 358. (Jun., 1980), pp. 314-329.
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Time to Build and Aggregate Fluctuations Finn E. Kydland; Edward C. Prescott Econometrica, Vol. 50, No. 6. (Nov., 1982), pp. 1345-1370.
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Real Business Cycles in a Small Open Economy Enrique G. Mendoza The American Economic Review, Vol. 81, No. 4. (Sep., 1991), pp. 797-818.
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